Mar 16, 2024

High Fees and Innovation - Bitcoin, an Antifragile System

Bitcoin Transaction Fees Surge: Ordinals & Lightning Network

High Fees and Innovation - Bitcoin, an Antifragile System

As an antifragile system, Bitcoin responds to attacks and threats by improving itself.

Transaction fees on the Bitcoin network experienced a substantial surge in the second week of December 2023, reaching levels not seen in almost three years. This recent increase in network costs associated with Bitcoin transaction fees has sparked renewed interest in the mechanisms behind the network and potential solutions. 

In time of writing, the 7-day moving average for transaction fees on the network has climbed to $28. This represents a significant rise, especially when compared to the period between Q3 2021 and November of this year when it consistently fluctuated between $1.50 and $3 (red circled area below).

Bitcoin Average Transaction Fees

Source: Ycharts

This is largely due to the introduction of Ordinals and Inscriptions in the first half of 2023, which have increased demand for block space and driven up Bitcoin transaction fees. This is largely due to the introduction of Ordinals and Inscriptions, which have increased demand for block space and driven up Bitcoin on-chain fees.

What are Bitcoin Ordinals and Inscriptions?

Bitcoin Ordinals are like NFTs on the Bitcoin Blockchain, but they use individual satoshis rather than whole coins.Satoshis are the smallest denomination on the Bitcoin blockchain, corresponding to one hundred millionth of a Bitcoin, or 0.00000001 Bitcoin.

Each satoshi is assigned a unique ordinal to track ownership and movement. Additional data, like images, texts, sounds or even video games can be attached to these ordinals through a process called inscribing, creating unique digital assets on the Bitcoin blockchain.

Types of Data Inscribed on the Blockchain

Source: Dune Analytics

Inscriptions can also be used to create BRC-20 tokens. They are semi-fungible tokens that can now be mined directly on the Bitcoin Blockchain.

Controversy and Impact on the Bitcoin Network

These implementations were designed to enable on the Bitcoin blockchain what was once considered a unique feature of Ethereum.

Although these innovations are a demonstration of the potential and veracity of the Bitcoin network, many industry experts have defined them as harmful to the Bitcoin ecosystem, and some even consider them a real attack on the Bitcoin network itself.

The Risks of Ordinals on Bitcoin

The reason lies in the fact that to create Ordinals and BRC-20 tokens, a particular implementation of the Bitcoin code, called Taproot, is used.

The Ordinals protocol launched on the Bitcoin mainnet and used some of the features introduced by Taproot (and SegWit), although many developers claim that this is not the use case for which Taproot was created.

Taproot was originally designed to improve transaction privacy and efficiency, not for storing large amounts of non-transactional data.

Addressing Concerns Over Ordinals and Inscriptions

“SegWit separates the witness from the list of inputs. The witness contains data required to check transaction validity but is not required to determine transaction effects.” Bitcoin Wiki

Before Taproot, the space for inscribing Ordinals on satoshis was limited due to the size constraints of the SegWit “witness” segment. However, Taproot's Tapscript functionality introduced a mechanism to efficiently store larger information, theoretically allowing up to 4MB of data, which is the maximum size of a Bitcoin block.

The thesis of the alleged attack on the security of the Bitcoin network lies in the fact that Ordinals and Inscriptions allow a large part of the space available in a block to be allocated to the storage of discretionary data, such as multimedia content, rather than data relating to transactions. Quoting the whitepaper written by Satoshi Nakamoto himself, Bitcoin is "A Peer-to-Peer Electronic Cash System", and not a database for storing multimedia content.

The Node Storage Challenge

Many purists view the tendency of Ordinals and Inscriptions to consume all available space as a potential threat to the sustainability of individuals running their own Bitcoin node. This is particularly concerning given that the current size of the blockchain can already be prohibitive for most users with standard home PCs, requiring over 500 gigabytes of storage.

This can also increase the fees for all users of the network.

Rising Fees: Miners vs. Regular Users

Although this factor has been a real godsend for miners, who have seen their revenues increase dramatically from one day to the next in the midst of the bear market, for the end users it is a problem. It makes the layer 1 of Bitcoin absolutely unusable for small transactions, and it also poses a problem for those who want to move their funds from a hot wallet to a cold wallet.

Bitcoin Transaction Fees Chart

Source: BitInfoCharts

With the 7-day moving average reaching $28, there is a need for an alternative solution for all those low-amount transactions, which were already unsustainable with fees ranging between $1.50 and $3.00.

Layer 2 Solutions: Lightning Network

“Complaining will only make them (Ordinal minters) do it more. Trying to stop them and they’ll do it in worse ways. The high fees drive adoption of layer2 and force innovation. So relax and build things.” Adam Back

Understanding Layer 2 Solutions

Layer 1 blockchains, like Bitcoin, handle the core aspects of transaction processing and security, employing consensus mechanisms like PoW. Layer 2 solutions, on the other hand, exist as secondary protocols built atop layer 1. They leverage the underlying network's infrastructure for security and consistency while optimizing transaction processing and throughput.

Layer 2 protocols are often referred to as scaling solutions, since they enable faster and cheaper transactions while still relying on the core aspects of the base layer. Bitcoin’s biggest and arguably best layer 2 solution is the Lightning Network.

Bitcoin's Scaling Solution

The Lightning Network offers an essential solution for reducing Bitcoin transaction fees, especially during times of high network demand.

How Lightning Network Works

The Lightning Network leverages secure, off-chain payment channels to enable high-speed, scalable, and low-cost Bitcoin transactions. It achieves this by establishing two-party ledger entries on the blockchain that require mutual consent for spending funds. These entries are updated frequently, and only the most recent version is valid, enforced by blockchain-parsable smart.contracts.By connecting these two-party channels, a network of payment paths emerges, similar to internet traffic routing. The nodes along these paths act as intermediaries, but their cooperation is not essential, as the payment's integrity is guaranteed by smart contracts that enforce atomicity (all or nothing) using time-locks.

A Basic Schematic of the Bitcoin Lightning Network

This innovative approach enables off-chain transactions with the assurance of on-chain enforceability. It's akin to making numerous legal agreements without constantly seeking court intervention. The blockchain acts as the ultimate arbiter, resolving disputes only when necessary, and ensuring deterministic outcomes.

Fees and Bitcoin’s Antifragile Ecosystem 

“Anti-fragility goes beyond robustness; it means that something does not merely withstand a shock but actually improves because of it.” Investopedia

In addition to motivating miners to validate transactions through additional revenue from block subsidies (which steadily decrease due to the halving algorithm), transaction fees serve the purpose of acting as an anti-spam/DoS measure.

The Proof-of-Work system itself was designed to make spam/DoS attacks costly.

Fees can be likened to the temperature of the human body, which in the event of an infection, rises to suppress potentially dangerous bacteria.

Fees are a fundamental component for the functionality of layer 1, and in periods of "flu", they behave exactly like a fever to suppress attacks capable of compromising the entire system, making them too expensive to carry out.

How Bitcoin Adapts and Innovates

As Adam Back said, high fees stimulate innovation and the adoption of layer 2 solutions, such as Lightning network.

As an antifragile system, Bitcoin responds to attacks and threats by improving itself, thanks to its decentralized nature and its open source code.

The Bitcoin ecosystem effectively addresses periods of volatility and the overall demand for scalability and efficiency through solutions such as the Lightning Network. It ensures the continued functionality of the network without hindering innovations built on top of it, such as Ordinals and Inscriptions, and guards against succumbing to exploitative attacks.

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